08 - CA 2 Reverses Tax Court Decision on Variable Prepaid Forward Contracts

Size: px

Start display at page:

Download "08 - CA 2 Reverses Tax Court Decision on Variable Prepaid Forward Contracts"

Nickolas Gilbert
5 years ago
Views:

1 08 - CA 2 Reverses Tax Court Decision on Variable Prepaid Forward Contracts Estate of Andrew J. McKelvey v. Comm., (CA 2 9/26/2018) 122 AFTR 2d The Court of Appeals for the Second Circuit has reversed a decision of the Tax Court, which had held the extension of the settlement dates of two variable prepaid forward contracts (VPFCs) did not result in either a taxable exchange or a constructive sale. The Second Circuit found that the extension constituted an effective replacement of the original VPFCs with new contracts and remanded the case for the Tax Court to determine whether the termination of obligations under the original contracts resulted in short-term capital gain. The Second Circuit also found that the amount of shares to be delivered at settlement was "substantially fixed" such that a constructive sale occurred, and instructed the Tax Court to compute the amount of long-term capital gain that resulted from it. Background. A standard forward contract is an executory contract in which a forward buyer agrees to purchase from a forward seller a fixed quantity of property at a fixed price, with both payment and delivery occurring on a specified future date. The VPFC is a variation of a standard forward contract, requiring the forward buyer (usually a bank) to pay forward price (discounted to present value) to the forward seller on the date of contract execution, rather than on the date of contract maturity. A forward seller can use the upfront cash prepayment however he or she deems fit; often, the proceeds are used by the forward seller to diversify a concentrated stock position into other securities or financial instruments. In exchange for the cash prepayment, the forward seller becomes obligated to deliver to the forward buyer: (1) shares of stock that have been pledged as collateral at the inception of the contract; (2) identical shares of the stock which have not been pledged as collateral; or (3) an equivalent cash amount. The actual number of shares (or cash equivalent) to be delivered by the forward seller is determined by a formula which takes into account changes in the market price of the underlying stock over the duration of the contract. (See Anschutz Co. v. Comm., (2010) 135 TC 78, aff'd, (CA ), 108 AFTR 2d ) As a general rule, the entire amount of gain or loss on a sale or exchange of property must be recognized under Code Sec. 1001(c). Under Code Sec. 1259(a)(1), if there is a constructive sale of an appreciated financial position, the taxpayer must recognize gain as if the position were sold, assigned, or otherwise terminated at its fair market value (FMV) on the date of the constructive sale. Under Code Sec. 1259(c)(1)(C), a taxpayer is treated as having made a constructive sale of an appreciated financial position if he or she (or a related person) enters into a futures or forward contract to deliver the same 27

2 or substantially identical property. With exceptions not relevant here, the term appreciated financial position means any position with respect to any stock, debt instrument, or partnership interest if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. (Code Sec. 1259(b)(1)) A forward contract is a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price. (Code Sec. 1259(d)(1)) In Rev Rul , CB 363, IRS recognized that VPFCs are open transactions when executed and do not result in the recognition of gain or loss until future delivery. The rationale is that a taxpayer entering into a VPFC does not know the identity or amount of property that will be delivered until the future settlement date arrives and delivery is made. In Virginia Iron Coal & Coke Co. (1938), 37 BTA 195, aff'd, (CA4 1938) 21 AFTR 1221, cert denied 1939 (Virginia Coal), the taxpayer wrote an option in exchange for an upfront cash premium. The option contract provided the optionee with the right to extend the option from year-to-year by making annual payments to the taxpayer on or before the first day of August. The optionee failed to make a timely extension payment for the third year, which allowed the option to lapse. However, the parties modified the option and agreed to continue it. The Board of Tax Appeals held that the continuation of the option prevented the taxpayer from realizing gain or loss in the year of lapse because the taxpayer maintained a continuing obligation to perform. The Board of Tax Appeals also reasoned that continuing open transaction treatment was appropriate because it was uncertain whether the premium payments would ultimately be included in the computation of gain or loss from the sale of the underlying property or would constitute income to the taxpayer in connection with the expiration of the option. In Freddie Mac, (2005) 125 TC 248, the taxpayer entered into prior approval purchase contracts to purchase mortgages from loan originators in exchange for a nonrefundable commitment fee. IRS argued that the upfront commitment fees did not constitute option premiums because it was a virtual certainty that the transactions would be consummated. The Tax Court first found that the prior approval purchase contracts had the economic substance of options and so applied the law and policy rationale governing options. Despite the high level of certainty that a transaction would be consummated, the Court held that some uncertainty remained whether the loan originator would exercise the right to sell the mortgage to the taxpayer, and whether the option was exercised or allowed to expire affected the tax treatment of the upfront premiums. The Tax Court found that there wasn't a sale or exchange and approved open transaction treatment. Under Code Sec. 1234A, gains or losses are capital gains or losses if they are attributable to a cancellation, lapse, expiration, or other termination of: (a) a right or obligation (other than a securities futures contract) as to property if the 28

3 property is (or would be, if acquired) a capital asset in the hands of the taxpayer (Code Sec. 1234A(1)); or (b) a Code Sec contract that is not described in Code Sec. 1234A(1), which is a capital asset in the hands of the taxpayer. (Code Sec. 1234A(2)) Facts. Andrew McKelvey, the founder and chief executive officer of Monster Worldwide, Inc. (Monster) entered into VPFCs (original VPFCs) with two investment banks in Under the terms of the original VPFCs, the investment banks made prepaid cash payments to McKelvey of approximately $194 million, and McKelvey was obligated to deliver variable quantities of stock (between about 5.4 million and 6.5 million Monster shares, then worth between $181 million and $218 million) to the investment banks on specified future settlement dates in 2008 (original settlement dates). McKelvey treated the execution of the original VPFCs as open transactions pursuant to Rev Rul and did not report any gain or loss for In 2008, before the original settlement dates, McKelvey paid consideration of approximately $12 million to the investment banks to extend the settlement dates until 2010 (the VPFC extensions; as extended, the amended contracts). McKelvey did not report any gain or loss upon the execution of the VPFC extensions and continued the open transaction treatment. McKelvey died in 2008 after the execution of the VPFC extensions. His estate settled the extended contracts by delivering approximately 6.5 million Monster shares worth about $88 million. McKelvey's 2008 income tax return, filed by the executor of his estate, reported no income attributable to the amended contracts. The estate's reason for not reporting any short-term capital gain was because the VPFC extensions did not result in a taxable exchange of the original VPFCs for the amended contracts. And, the estate's reason for not reporting any long-term capital gain was because such a gain could not have occurred until the amended contracts were settled by delivery of Monster shares to the banks, by which time the shares had acquired a stepped-up basis following McKelvey's death under Code Sec. 1014(a)(1), and the stock price had declined between the date of death and the settlement date. In this case, the treatment of the original VPFCs was not in dispute: both parties (IRS and McKelvey's estate) agreed that when the original VPFCs were entered into in 2007, the contracts satisfied the requirements of Rev Rul , and no current gain or loss was recognized.." However, on audit, IRS determined that the execution of the VPFC extensions in 2008 constituted sales or exchanges of property under Code Sec and that McKelvey accordingly should have reported over $200 million in gain from the transactions for IRS reasoned that: (i) McKelvey realized a short-term capital gain because the VPFC extensions resulted in taxable exchanges of the 29

4 original VPFCs for the more valuable amended contracts, which IRS deemed to be forward contracts under Code Sec. 1259(d)(1); and (ii) McKelvey realized a long-term capital gain because the number of shares to be delivered at settlement of these forward contracts was substantially fixed within the meaning of Code Sec. 1259(d)(1), resulting in constructive sales of the Monster shares that he had pledged as collateral under what IRS deemed to be forward contracts. Tax Court's conclusion. The Tax Court held that McKelvey's execution of the VPFC extensions did not constitute sales or exchanges of property under Code Sec. 1001, and the open transaction treatment afforded to the original VPFCs under Rev Rul continued until the transactions were closed by the future delivery of stock. The Tax Court reasoned that, in Virginia Coal and Freddie Mac, it approved open transaction treatment because it was uncertain whether the options would be exercised or allowed to expire, and the uncertainty directly affected the taxpayer's treatment of the upfront option premium. Similarly, in this case, the Court found that ample uncertainty existed regarding the nature and amount of the gain or loss. In addition, the Court further held that McKelvey did not engage in constructive sales of stock in 2008 under Code Sec IRS appeal. IRS appealed the Tax Court's decision, arguing that a short-term capital gain occurred because either (1) the extension of the valuation date resulted in an exchange of property with a more valuable amended contract replacing the original VPFC; or (2) a termination of the delivery obligation occurred because the obligation in the first contract to deliver shares on the original settlement date was extinguished. IRS also contended that the execution of each new contract resulted in a constructive sale of the shares pledged as collateral to secure the obligation of the new contract, thus triggering long-term capital gain. Second Circuit reverses & remands. The Court of Appeals for the Second Circuit first noted its agreement with the Tax Court that McKelvey did not incur a shortterm capital gain on the basis that replacement of the VPFCs with the amended contracts was an exchange of property under Code Sec. 1001(c). At the time the VPFCs were extended, McKelvey no longer had any rights in the contracts that could constitute property and had already received the $194 million prepayments from the banks, and nothing else was owed to him. He had only the obligation to deliver Monster shares (or their cash equivalent) to the banks in September 2008, and obligations aren't "property." However, the Second Circuit sided with IRS on its alternative claim for the realization of short-term gain: that McKelvey's obligation under each VPFC was terminated when he executed the amended contracts, giving rise to short-term 30

5 gain under Code Sec. 1234A(1). The Circuit Court agreed with IRS that the VPFC extensions resulted in amended contracts that replaced the original VPFCs. And, a material change to an original contract that fundamentally changes its substance is considered an exchange of the original contract for the amended contract under Rev Rul and the extensions in this case represented a fundamental change, as shown by the fact that McKelvey paid almost $12 million to make this change. The Second Circuit thus remanded the case to the Tax Court to determine whether the replacement of the obligations in the original VPFCs with the obligations under the amended contracts should be considered a termination of obligations that gives rise to capital gain. IRS also argued that the VPFC extensions resulted in a constructive sale of the shares pledged as collateral, generating a long-term capital gain. IRS reasoned that a constructive sale under Code Sec occurs when a taxpayer holds an appreciated financial position which McKelvey's Monster shares clearly were on the dates of the amended contracts in stock and enters into a forward contract to deliver the same or substantially identical property. A forward contract is defined by Code Sec. 1259(d)(1) as a contract to deliver a substantially fixed amount of property (including cash) at a substantially fixed price. The disagreement between the parties was whether what McKelvey had to deliver was "substantially fixed" for constructive sale purposes. IRS asserted that the amount of Monster shares to be delivered at settlement of each amended contract was "substantially fixed" as of the date each contract was executed, and the Second Circuit agreed. IRS reasoned that the stock price had significantly dropped such that it was a virtual certainty that the price wouldn't recover (i.e., wouldn't rebound to the "floor" value under the contract) and that McKelvey would therefore be contractually obligated to deliver all of the collaterized shares pledged under each amended contract. This certainty, IRS concluded, meant that the amount of property to be delivered at settlement was "substantially fixed" under Code Sec. 1259(d)(1) and that the collaterized shares had thus been constructively sold. IRS introduced probability analysis that indicated that the probability that the stock would exceed the floor value was approximately 15% under one of the bank contracts and approximately 13% under the other. While noting that the issue of whether probability analysis can be used to determine whether an amount of property is "substantially fixed" under Code Sec. 1259(d)(1) was a novel issue, the Second Circuit ultimately found that tax laws are applied "with an eye to economic realities" (Frank Lyon Co. v. U.S., (Sup Ct 1978) 41 AFTR 2d ), and that the analysis used by IRS was widely accepted, so it accepted the analysis for this purpose. The Second Circuit also found that, to hold otherwise and not allow a "substantially fixed" determination on the basis of probability analysis would effectively allow similarly 31

6 situated taxpayers to sign similar extensions until death, at which time shares will have a stepped-up basis in the hands of the estate allowing taxpayers to forever escape capital gains tax that would have been due had the original upfront payment resulted from a sale of stock. While the frequency of such situations is limited, the Court found that the Code "should not be readily construed to permit that result." Thus, having determined that constructive sale treatment should apply, the Second Circuit remanded to the Tax Court to calculate the amount of long-term capital gains that resulted from the constructive sales of the collateralized shares. 32

Fed. Home Loan Mortg. Corp. v. Comm'r 125 T.C. 248 (T.C. 2005)

Fed. Home Loan Mortg. Corp. v. Comm'r 125 T.C. 248 (T.C. 2005) CLICK HERE to return to the home page OPINION RUWE, Judge: Respondent determined deficiencies in petitioner's Federal income taxes in docket